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Saturday, July 8, 2017

Why Does the US Dollar Remain at the Center of the Monetary System?

In doing research for this blog I run across a lot of articles and information. In this case I think I may have found an article that sums up why the US dollar remains at the center of our present monetary system in two paragraphs. Below are the two paragraphs from this article appearing in Outlook Business followed by some additional comments.

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"The ability to have the preeminent reserve currency, without it being locked to a finite good such as gold, gives the US enormous advantages. For all intents and purposes, US dollars (and Treasuries) are gold. As my colleague James Montier has suggested, the US is like Rumpelstiltskin spinning out gold at will. The current account deficits that the US runs most years mean that the world is willing to give the US goods and services for the privilege of owning pieces of paper (indeed as a friend noted, they are not even pieces of paper, they are electronic credits). 

However, others argue that the preponderance of the dollar is a core point of global financial instability. The IMF has suggested that a more multilateral currency framework, or enhanced use of SDRs (special drawing rights), would be beneficial to global financial stability, including utilizing the Fund to act as a lender of last resort to those requiring flight-to-quality liquidity. In short, if the dollar is the reserve currency of the world, how does the Federal Reserve set appropriate monetary policy for the US? It’s a question that is under debate during this current phase of Federal Reserve monetary policy tightening."
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My added comments: I am not sure you could describe the enormous incentive the world seems to have to stay tied to the US dollar any better than this. It is clear that the US has "enormous advantages" doing this so we are not surprised it wants the dollar to stay at the center of the system. But why would the rest of the world also go along with this?

I have come to the conclusion that the majority of the world has become so dependent on the idea that the US dollar is a safe currency for so long that changing that perception has become almost impossible for anyone now so long as things appear stable. While many various interests around the world are making attempts to try and get something to challenge US dollar's reserve status, an entire generation has grown up now not knowing anything else. It is simply very hard to make a huge sea change like this unless events force that kind of change to take place. This is why I have decided it will most likely take a new major global financial crisis of the kind Jim Rickards and others have talked about to shake the world's desire to hang on to the US dollar. 

We have documented here that all kinds of risks to stability of the present US dollar based system do exist. We have quoted expert after expert who can make very compelling and logical arguments as to why the US dollar could lose this status almost at any time due to one or more of these systemic risks. There is persistent speculation that China intends to replace the US dollar some day. All that remains true even though the present system appears pretty stable to most people who don't think much about all this as they live their daily lives.

But until something changes this statement quoted in the above article . . .

"The ability to have the preeminent reserve currency, without it being locked to a finite good such as gold, gives the US enormous advantages. For all intents and purposes, US dollars (and Treasuries) are gold. As my colleague James Montier has suggested, the US is like Rumpelstiltskin spinning out gold at will. The current account deficits that the US runs most years mean that the world is willing to give the US goods and services for the privilege of owning pieces of paper (indeed as a friend noted, they are not even pieces of paper, they are electronic credits)."

. . .  I do not expect much to change. No matter how much debt or many  future debt obligations the US piles up and no matter how much money the US Federal Reserve creates when necessary in times of stress, the bottom line stays the same so far. People everywhere will happily exchange real goods and services for US dollars. People will sell you a barrel of oil for $45 US dollars. They will sell you a pretty decent car for $20,000 US dollars. They will sell you a decent home (in most locations) for $200,000 US dollars, etc. Even people who sell newsletters advising their clients that the dollar is doomed happily accept dollars in payment. They do this because , at least for now, they completely trust the US dollars you are giving them in exchange, period. Those who do not trust them are a tiny fraction of the population as of today.

All this despite the fact that everyone knows the US has a ton of debt, came close to financial collapse as recently as 2008, and has a banking system loaded to the gills with all kinds of leverage on top of all the government debt it has. If any of this creates a liquidity problem, we can simply go down to the basement at the Fed and turn on the US dollar creation machine (see humorous note here) and magically create whatever amount we need to get past the latest problem. Again, everyone knows we are doing this and still happily accepts as many of these US dollars as you will give them in exchange for real things with complete trust in those US dollars.

Until that attitude changes, the US can get away with this. It really is that simple. 

So, why and when will this attitude ever change?

That is the $64,000 question that no one has an answer to. We do know that nothing lasts forever and that some day some event or series of events will likely happen that shakes the trust the world has right now in the US dollar to the core. It could be any of the risks we already are aware of, or something that comes out of nowhere that no one has thought about. China and Russis clearly want to change the status quo. It could happen next week or not for a long time. Numerous predictions of the demise of the dollar have failed thus far.

This is what makes our situation so difficult to plan for. Somehow, we need to have a plan that allows us to exist in the status quo for some unknown period of time into the future while at the same time having some kind of backup plan that tries to deal with a world that no longer trusts the US dollar. A world like that would be at the extreme opposite end of where things stand today. The investment strategies for each of these conditions are very different so diversification is even more essential than usual. You even have to allow for being able to function for a period of time if something unexpectedly takes down the entire system for any reason (Russian hacking, derivatives meltdown, too big to fail failing, etc).

All we can do here is to try and encourage people to study these issues, understand the systemic risks, and prepare some kind of backup plan in case the sea change we watch for here really does arrive in our lifetimes.  To do that, we need to understand the known risks that exist to the present system. We also need to try and understand the various reasonably credible proposals out there to try and deal with this kind of monetary system change if it were to actually happen. 

We have done that here to the best of our ability while openly admitting that we cannot predict the future or what will actually happen. What we can do is look at the various potential future scenarios that are reasonably realistic and some of the various ideas for a new monetary system (examples here and here and here) that have been proposed. The fact that there are so many ideas out there for new money (we seem to get a new currency every day now) indicate that many expect the present system to eventually fail and are positioning now to have their ideas considered in a future new system. Meanwhile, until something does change the current system, we will continue to monitor events to see what actually happens. 
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Added notes: This followup article appearing in Outlook Business is also a worthwhile read.

Recently the BIS hosted a speech about booms, busts and risks to the monetary system. The speech was given to a room full of central bankers from all over the world. In this panel discussion after the speech, it is pretty clear that everyone understands the US dollar is the "elephant" in the room. When you listen to these kinds of discussions, it becomes very evident that no one in the central banking world expects the US dollar to be replaced as global reserve currency any time soon. The assumption in the room is clearly that everyone else will just have to accept that the dollar is the reserve currency and try to adjust to US monetary policies that impact the dollar as best they can.

Added news note: King World News runs this followup interview related to the Andrew Maguire news today. We will continue to monitor this to see where it goes.

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